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Over at Conde’ Nast’s Daily Traveler, Cranky Flierargues that profitable airlines make investments in product and the title of the post asks whether airline fees are starting to pay off for passengers — the idea is that fees helped make airlines profitable, so fees are driving a better flight experience.

And then he talks himself into a headache making heads or tails of his own argument.

Now we have a twisted circle where economy class passengers pay ancillary fees to subsidize amenities for first class passengers in order that first class fares remain competitive so that first class passengers will still buy tickets and subsidize the economy class fares. It’s all starting to give me a headache.

And I start to wonder, do we all just need to step back and remind ourselves how airline pricing works, and about the difference between average cost and marginal cost?

Both High and Low fare Passengers Can Be Profitable

Airlines practice ‘revenue management’ in order to charge passengers as close as possible to the amount they’re willing to pay. If a customer isn’t price sensitive, if they really need to travel, why charge them $200 when they’ll pay $1000?

At the same time, if you aren’t going to fill up all the seats on the plane at $1000, you are happy to see the extra empty seats go for very little. Because it costs next to nothing – certainly less than $50 – to cover the incremental cost of an additional passenger. Virtually any revenue you get is going to be gravy, enhancing your bottom-line.

Airlines live off of high fare passengers, and especialy frequent high fare passengers. But once they decide to fly a route, and once any seat is otherwise going to go empty, the revenue from low fare passengers goes straight to the bottom-line.

They won’t make money on low fare passengers alone. But once they’re going to operate a flight, a decision driven by expectations of a certain number of those higher fare passengers (for most airlines), the cheap tickets will help fill seats that tip them from running in the read to being profitable on a given flight.

Why Airlines Charge Ancillary Fees

On the whole coach seating is an unpleasant experience, although some would argue that a little bit more legroom on JetBlue or the pimped out entertainment technology on Delta or Virgin America can make things a bit more tolerable.

Consumers love to rail at the airlines but we get the coach product we actually want, or at least the product that on the whole people are willing to pay for.

American Airlines experimented with ‘More Room Throughout Coach’ — extra legroom for all passengers in the cabin. But they couldn’t get people to book away from other airlines with the product, and they couldn’t earn a revenue premium with the product. It didn’t make financial sense for them, and they ripped out the seats, since people still preferred the lowest price for less comfort (at least enough people did that they couldn’t afford to give everyone more room).

In contrast, United’s ‘Economy Plus’ model survived where a certain number of seats on each flight have additional legroom, and customers get those seats either by buying frequently from the airline or by paying extra for them on a given flight. They earn more from those seats, so it makes sense to offer them.

Ancillary fees accomplish two things:

They unbundle prices, to let consumers pick and pay for those services that they want and not those they do not.

They shift funds away from the ticket price. Airfares are subject to a 7.5% federal excise tax. Ancillary fees are not. So the more revenue that can be moved out of the ticket and into ‘fees’ the lower the tax and more revenue kept by the airline.

When – And Why – Airlines Don’t Charge Ancillary Fees

Elite frequent flyers may or may not be paying a high fare on a given trip, but airline frequent flyers contribute an outsized portion to the bottom-line. Frequent customers as a group are profitable and treating them well retains them, at least that’s the bet, so if some services are offered free it creates a reason for those customers to continue to choose the same airline.

While there may be individual unprofitable customers, airlines are making money on their frequent flyers even if they give them the occasional free checked bag.

Certainly their total revenue contribution to an airline is much greater than the occasional passenger, even if the once a year traveler pays a checked bag fee. And since in an industry with high fixed costs and low marginal costs the determinant of whether an individual flyer adds value to the bottom line is the total revenue generated (as low as each ticket is sold meaningfully above marginal cost), the airlines make money by comping those checked bags.

Additionally, paying high fares such as intenrational business class tickets — which may cost $4000 or $10,000 or more — companies may be willing to shell out the fare but not pay for individually itemized charges like cocktails on an employee’s expense report. Bundling free drinks and bedding is a way of encouraging the employee to select the airline, directing their employer’s resources to that airline’s seats. It’s precisely because those customers are profitable that airlines want to spend more to bid for their business.

The very fact that airlines ‘give free’ bedding and drinks and checked bags is an indication that the airline believes the fare paid is a profitable one. And in fact they aren’t giving the passenger those things for free, they’re just bundling them into the ticket price.

They are charging ‘Joe Sixpack’ what they can for the services provided. And they are giving services they believe necessary to compete for the business of ‘Ritchie Rich’ or whatever mid-level manager is buying the premium cabin seat as well.

The confusion comes in because Cranky Flier suggests that premium services and investment in product comes from profitable airlines. But it’s not that they’re using the profits to then ‘pay for’ the premium services. They’re paying for the premium services as a way to seek even greater products.

When airlines are losing money, the first thing they try to do is stop the bleeding. It’s harder to justify an extra olive in a first class salad because usually there’s little evidence to suggest that the olive will make a difference either way in a customer’s purchase decision.

Unprofitable companies tend to have an accumulation of decisions over time that are costly, and a bankruptcy process or other restructuring including cutbacks can be a way to start fresh. Sometimes you cut good investments along with the bad, but if you don’t do that then it’s easy to make the case one-by-one for each status quo decision — the sum total of which were leading to losses.

In addition, unprofitable carriers don’t have nearly as much access to capital , or inexpensive capital, as profitable ones.

Turn things around and you can buy expensive new products at lower interest rates. Profitable carriers pay less for new product investments, so those investments can make more sense.

But none of that has anything to do with taking checked bag fees and ‘using that money’ to pay for champagne or pajamas up front. Rather ancillary fees have been a part of the way the industry has recovered — raising more revenue on customers who are obtaining greater service from the airline at a time when flights are also filling up and they’re in a position to do so. And newly profitable carriers then look to invest in product as the next way to making more money, attracting more high yield passengers, since planes are full and they can’t just sell more seats without engaging in even costlier strategies like operating more flights (where they’d likely b trying to fill seats at a lower price).

So Who Is Subsidizing Whom?

The premium product investments that Cranky Flier and Hack My Trip are talking about are:

A partnership with Westin to bring their Heavenly bedding to business class cabins.

The installation of those lie-flat beds in business class cabins.

Renovation of Delta SkyClubs.

Adding WiFi and Economy Comfort seats to the economy class cabins.

Oddly enough these are the least likely candidates for accusations of ‘subsidy’.

There’s a cross-marketing relationship between Delta and Starwood designed to generate incremental business for both companies, so branding bedding with the Westin name doesn’t come out of someone’s checked bag fees. United previously tried a marketing tie-in with Westin (ironically enough, United used to own Westin hotels). And they had a Westin ‘Renewals’ lounge in at least one of United’s Red Carpet Clubs about four years ago.

Lie flat beds are what people are paying several thousands of dollars for, several multiples the price of a coach ticket, it seems uniquely odd to say that an $800 ticket is subsidizing the $8000 one. And if it was, why would the airline do it?

Delta has been renovating Skyclubs but also cutting back on the free booze and increasing the price of those clubs. I don’t think there’s a credible claim that the profit and loss accounting for the clubs requires a transfer payment from checked baggage.

Charging for inflight wireless internet is something that currently isn’t even bundled into the price of a premium cabin ticket, it’s generaly paid for by both coach and business class passengers alike. Moreover, airlines install wifi because if they don’t passengers will book tickets on other carriers instead. US Airways made their decision a year ago to install wireless internet not because they were going to make money on usage fees, but because they saw they were losing business to airlines with wifi.

The idea of a ‘subsidy’ in this context just doesn’t make sense. You have high fare passengers covering an airline’s fixed costs, and low fare passengers more than covering the airline’s marginal costs. Together they can generate profits.

Related

I have not run the numbers to ground, but it strikes me that EVERYONE on a plane is getting subsidized. Again, no data to share, but can the applicable excise taxes and airport use fees truly cover the costs of operating the airports (including land acquisition, construction, depreciation, etc.) and air traffic control system? Also, please don’t get me started on the Essential Air Service and its gross subsidies. (And, I’d be interested in more data, even if it proves me wrong).

I like for other people to subsidize my lifestyle as much as the next dude. But my initial reaction is that air travel is rife with subsidies, both for coach and business class.

@jfhscott – a totally different although valid question. Here I limit the discussion of whether the ticket purchases of one cabin subsidize the tickets purchased in the other. But whether air traffic is on net subsidized or on net a source of tax revenue is a worthy discussion (airport fees, federal excise tax on domestic tickets, I do think that income taxes paid by the airlines should count here as well vs airports authorities, FAA… and then a totally separate question is whether if there is any subsidy it’s really a subsidy of the travelers or of an inefficient aviation system that the travelers have no say in because it comes from a monopoly provider…)

Robert said,

Gary, stop making sense…the other bloggers won’t appreciate it…

Nic said,

Of course they are. Just look how many of the top 10 airports in the US don’t have an oligopoly. Low competition equals higher prices and the only one getting more benefits are first class passengers.

DBest said,

Why doesn’t it make sense for an upstart airline to charge fixed fares, based on miles flown? I understand they’d be undercharging some customers but wouldn’t they fill the plane anyways, since their fare structure would poach their competitor’s customers?

UnitedEF said,

Thanks for not going into class warfare mode like the others. I learned long ago why there are certain a holes in expensive cars who drive like they own the road: because they paid for the majority of it. No ill will but those are the facts. Like you said those that pay the F, A, P, J, C and even Z, Y, B are the ones that bring in the money. Thanks for being rational.

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BTW we applied for the Gold Premier Rewards AMEX through your link a couple of months ago.

And I trust that carriers will generally extract what they can from whomever they can without regard to class of service. Nor do I believe that any carrier incorporates some sort of “reverse Robin Hood” policies in their business model.

Now who’s being uncharitable? I updated my post within an hour after first posting it to make my point more clear: “I don’t actually think this is Delta’s strategy, but it’s my interpretation of Brett’s post.”

You start out by arguing that Brett’s contention is “profitable airlines make investments in product,” but what he actually said is, “fee revenues have allowed airlines to start investing in their products again.” And so I discussed how the people who benefit from most improvements and the people who pay most fees are not the same group.

[…] explains the business practices of airlines and how Scott’s analysis is more or less misguided as…. His explanation explains why all of the pricing is a rational way to get the most revenue out of […]

@Scottrick and @Gary. Thank you for two thought provoking posts. I really think that the airlines reflect the wider economic disparity in the US and the world. They have to serve the needs of very different constituents. In my opinion and as I just wrote I think Gary’s analysis is right on the money, but Scottrick is right in the broader picture at trying to capture and explain the manner in which most economic spoils are going to fewer and fewer. This is borne out statistically and no less a conservative publication than The Economist newspaper is concerned about the growth in inequity.

jfhscott said,

@Scottrick and other interested parties,

Perhaps the most bizarre aspect of the Snyder article is the premise based on the following quote:

“those fee revenues have allowed airlines to start investing in their products again”

How does Mr. Snyder specifically identify “fee revenues” as opposed to any other particular revenues as being the source of the funding for investments?

When I was little, if my grandfather gave me $5 and I immediately went to the toy store and bought a toy, I could make such a specific identification between the cash gift and the toy, as Mr. Snyder does between fee revenue and product investments. But I’m a grown up now, and “I cannot diffentiate dollars in (paycheck, revenues from ebay sales, rebates, etc., etc,), marrying them to dollars out (mortgage, groceries, boarding the dog, etc.).

Unless Mr. Snyder has evidence that “fee revenue” went directly into a designated “product enhancement account”, his insinuation of a cause and effect strikes me as strained and unsupported. He may have more (undiclosed) information than I do, but I have never heard that “fee revenue”, and not general revenue sources, finance improvements to premium cabins.

@jfhscott That was my point, on the nose. Sometimes my thoughts don’t come out so well when I write them down.

Robert Hanson said,

“most economic spoils are going to fewer and fewer”

This comment is not “travel related”, but if AJTrenkle is going to post his class warfare disinformation, I think it deserves a response:

Also from the Economist:

“The inequality myth
Is rising inequality in America exaggerated?”

“In a recent paper weaving together several strands of new research, Mr Gordon reports that improved use of income datasets “shows that there was no increase of inequality after 1993 in the bottom 99 percent of the population”.

And this from the AEI:

“New study undercuts Obama’s income inequality argument”

…new research by Philip Armour and Richard Burkhauser of Cornell University and Jeff Larrimore of the Joint Committee on Taxation raises questions about those two studies and their conclusions. Here are their two key findings:

1. All income levels saw expanding incomes from 1979-2007. There’s been no income stagnation for the middle class.

2. While inequality has risen, it was mostly if not almost entirely a 1980s phenomenon.”

“we observe that incomes have risen throughout the distribution and since 1898 have largely risen uniformly throughout the distribution.”

“Inequality growth has not risen in recent years, as the top quintile of the income distribution had the slowest growth from 1989 through 2007 while the bottom quintile had the fastest”.

For the full articles, just google the article titles listed above.

Robert Hanson said,

The date in second to last quoted paragraph was transposed. The correct date is of course 1989.

FlyingBear said,

How about comparison of fees per square foot on the plane plus the cost of the meals/amenities or some other hard comparison? This whole without-numbers-rebuttal-just-’cause-I-said-so doesn’t really go much beyond he-said/he-said argument.

Although the advantages of First and Business travel usually relate to Service and space the airlines usually focus on weight and space otherwise lost to higher revenue. On a basis considering weight and space the Business class passengers are no bargain for the airline. They also benefit from flights available more often than if the flights were C class only.

Robert Hanson said,

@FlyingBear “comparison of fees per square foot on the plane”, apparently without regard to cost of tickets per square foot on the plane. And “he-said/he-said argument” WTF?

@ Charles If it were more profitable to be C only, all the flights would be C only, or Southwest would put everyone else out of business. That apparently is the case with FC, thus we are seeing cut backs in FC space on most airlines. Business class being increased clearly means that most airlines think they make greater profits from Business than from economy or FC. But then again, what do they know compared to you?

I recognize you are probably just trolling and I don’t want to get into it on Gary’s blog, but the AEI is hardly an objective scholarly source to cite.

Income inequality has been well researched and has risen significantly since the early 1970s. Saying this does not represent “class warfare” as I have no problem with wealthy people. Policy matters are a question of political discourse rather than evangelizing. Suggesting that we would notice this inequality in the air travel business and that airlines would (rightly) seek to serve two different flying markets simultaneously and successfully, I believe, is travel related and directly relates to the topic of this post.

Jim L said,

Another variable (maybe a red herring) is that most if domestic first, on AA at least, is filled with upgraded flyers. It would be interesting to know the percentage of F and J seats sold versus upgraded. If the upgrade percentage was high, wouldn’t that tilt the argument toward economy subsidizing F and J?

Robert Hanson said,

@AJ First of all, I began with an article from the same source you used, the Economist. Then followed with the AEI article since it included more well researched studies that supported the previous article.

The AEI article is not hyperbole, it summarizes and quotes well researched academic studies done by others. Which you seem to think can be easily dismissed by pointing out that AEI is a conservative organization. As the saying goes, you are entitled to your own opinions, but not your own facts.

I note that you ignored the central fact I posted. “Income inequality has been well researched and has risen significantly since the early 1970s” may be true. But my point is that almost all of that growth came during the 80’s. And far from rapidly increasing at the present time, has at least significantly slowed down over the following decades, and most likely reversed recently.

If you have documented facts to refute that, I’d be interested in finding out about them. But just to say you don’t like the AEI agenda hardly counts as such.

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